EMU’s paradoxes

The single currency is coming, but its economics is not all it is cracked up to be

A SINGLE currency for Europe sounds like a project that should be assessed mainly on its economic merits. Yet the first of many paradoxes about EMU is that it has come to be seen, above all, as a political affair. Jacques Chirac's gamble of bringing forward the French parliamentary elections to this spring, nearly a year ahead of time, was specifically designed to help France qualify for EMU membership. Germany's Helmut Kohl has put all of his considerable weight behind the launch of the euro. In Britain, the single currency cast a shadow over the recent election. And for the governments of Italy, Spain and Portugal, qualifying for the first round of EMU has become a full-time preoccupation.

To be sure, EMU always had a political dimension. Although John Major denied it, the Maastricht treaty was an explicit step towards the ambition of “ever closer union” expressed in the Treaty of Rome. Eurosceptics are against the single currency on grounds of sovereignty, not economics. Yet the initial motive for EMU was economic: the single currency was seen as a logical extension of the single market, the EU's greatest achievement to date. As Etienne Davignon, a vastly experienced former Belgian commissioner, puts it, “the single currency is the only thing that can unleash the full potential of the single market.”

Not only that, but without some way of stopping excessive currency fluctuations (“competitive devaluations” in French parlance), the single market could be put at risk by a revival of protectionist pressures. The abolition of capital controls in 1990 was crucial; the far-sighted understood that the existing exchange-rate mechanism might not survive, and were duly proved right in 1992-93. That made EMU the only feasible route to currency stability.

There are other gains to be had from a single currency. Over the past few decades many European countries have suffered from irresponsible monetary policies. Handing the monetary reins to an independent European Central Bank modelled on the German Bundesbank would ensure discipline, enabling Europe to entrench low inflation and create a climate conducive to faster economic growth. Cutting out transaction costs would produce useful savings, perhaps as much as 0.5% of Europe's GDP. The end of currency uncertainty should also boost investment across the continent.

Neither here nor there

Yet the economic arguments for EMU are not entirely clear-cut. The EU is not what economists call an “optimal currency area” with broadly homogeneous conditions. Some countries, such as Britain, appear to be on unsynchronised economic cycles, and some look vulnerable to “asymmetric” shocks that might affect them more than others. Devising a one-size-fits-all monetary policy for such a diverse area might prove hideously difficult, and European economies are not flexible enough to cope with the potential problems. There is very little labour mobility between countries, and no systematic mechanism for fiscal transfers to countries and regions that might lose out from monetary union.

These difficulties should not be exaggerated. America does not look like an optimal currency area either. If the single currency forces governments to make their economies more flexible, as many of its proponents hope, it will bring extra benefits, not impose greater costs. Besides, the biggest need for more labour mobility and for fiscal transfers to cope with shocks is likely to go on arising within individual member countries (eg, between northern and southern Italy), rather than between them. However, the benefits of EMU can be exaggerated too. A dispassionate economist might conclude that the economic arguments were fairly evenly balanced.

None of this much concerned Mr Kohl at the time of the Maastricht treaty, however. He and Jacques Delors, the commission president, always saw the project as primarily political. And yet many Germans were not keen. As they saw it, they were being asked to sacrifice the D-mark, the secure anchor of German prosperity and of Europe's monetary system, for the benefit of others. As a quid pro quo, the Germans therefore asked for movement towards closer political union. They got some of what they wanted at Maastricht, and are still hoping for more. They also demanded tight rules for joining the single currency, and tough controls on borrowing by member states after entry. These were the pressures behind the Maastricht criteria and, later, the stability pact (see article).

The official reason for restricting public borrowing is to ensure that the single currency will be as strong as the D-mark. Yet—another paradox—the economics of this is pretty dubious. A currency's strength is determined more by the markets' perception of monetary policy than by fiscal policy. Indeed, as both America and, ironically, Germany found in the 1980s and 1990s, big budget deficits, if allied to tight monetary policy, often strengthen rather than weaken a currency by increasing foreign demand for it. It is also notable that the only existing monetary union in Europe, between Belgium and Luxembourg, brings together two countries that have for years had respectively the biggest and the smallest public debts in the EU.

Nor is there much in the notion that, once a single currency is in operation, profligate sovereign borrowers will weaken it or push up interest rates. It ignores the arrival of genuinely global capital markets. It also ignores the provision in the Maastricht rules that credit risk will remain firmly with the sovereign borrower: the European Central Bank will be formally forbidden to bail out any national government. Nobody would suggest that if, say, Mexico borrows in dollars, it pushes up dollar interest rates or somehow impairs America's creditworthiness.

As for the stability pact, it seems perverse to impose artificial constraints on borrowing when both monetary and exchange-rate flexibility have just been removed and greater fiscal flexibility may be needed to compensate. The imposition of central rules could also confuse the markets by creating the impression that the EU would, if need be, stand behind a government's debt. And the idea of fining a country that incurs an “excessive” deficit smacks of the absurdity of a Dickensian debtors' prison.

Yet it was, and remains, true that Europe's governments had to return to fiscal prudence to safeguard their economies' longer-term health and competitiveness. Here is yet another EMU paradox. The criteria may be capricious, and the stability pact positively perverse; but the policies that European governments have adopted to try to hit the targets have been largely beneficial. Europe badly needed a dose of fiscal discipline, even if it was a case of doing the right thing for the wrong reasons.

The Germans, for their part, had a simpler, not-so-hidden agenda: to set such tough conditions as to make it impossible for Italy, and probably for Spain and Portugal as well, to join the single currency from the start. German officials make no secret of their desire for a “small” euro in the first instance, probably made up of Germany, France, the Benelux trio, Austria and perhaps Ireland or Finland. Econometric studies, they say, suggest that monetary policy would be more predictable and easier to run with a small group. The outliers' long-run record of stability is far from confidence-inspiring (see chart 2 on previous page). “Convergence” for Spain, for example, is far more recent, and therefore less reliable, than it is for the Netherlands, which began its economic reforms a decade ago.

SURVEY

But the clinching factor for Germany was the fear that its public, already dubious about the euro, would be more hostile still if less stable Mediterranean countries were included. Opinion polls have consistently shown that a solid majority of Germans is against giving up the D-mark. Yet now, in another EMU paradox, it is the Germans who could be hoist with their own Maastricht-criteria petard.

The commission's latest forecasts optimistically suggest that all EU countries bar Italy (just) and Greece (by miles) will comply with the Maastricht criteria this year (see table 3). Commission insiders have talked of ten countries joining the euro, leaving out only Britain, Denmark and Sweden (by choice) and Italy and Greece (because they will fail the criteria). But independent forecasters put Germany's budget deficit this year at 3.2-3.4% of GDP. Germany's public-debt performance also clearly fails the criteria, which specify that debt must be below 60% of GDP, or at least moving that way.

SURVEY

The Germans are now engaged in an undignified scramble for cash, including a revaluation of their gold reserves and a fire-sale of Deutsche Telekom shares. The decision on who can join the euro will also take forecasts for 1998 into account. That could scupper Germany; and also France, which is relying on a one-off payment from France Télécom worth 0.5% of GDP to push it below the 3% limit for 1997.

Read carefully, the Maastricht treaty allows plenty of wiggle-room But both Mr Waigel and Mr Kohl have repeatedly stressed that the criteria must be interpreted strictly. This presents the Germans with an awkward dilemma. Do they go ahead with fudged figures, risking political and legal challenges and perhaps making it impossible to keep Italy out? Or do they delay the project for a year or two, in the hope that their numbers will improve? Plenty of German voices have been raised in favour of the second option, some coming from inside the Bundesbank, but Mr Kohl has dismissed such talk. His fear is that delay may cause the project to be cancelled altogether.

Better late than never?

Yves-Thibault de Silguy, the EU's (French) economics commissioner, also fiercely opposes postponement. He points out that there is no provision for it in the treaty, which says merely that EMU will begin on January 1st 1999 with as many countries as are able to join. This difficulty might be overcome by declaring that nobody qualifies; but setting a new legally binding date would require a treaty amendment. Mr de Silguy, along with most senior French officials, also believes that any delay could be tantamount to cancellation, though the top ranks of the Bank of France have been less certain about this.

Presenting delay as a likely catastrophe, rather than a largely technical matter, carries risks of its own: if postponement became inevitable, its consequences would be more serious than they need be, the EU could be seriously weakened and enlargement could be in jeopardy. Peter Sutherland, a former commissioner now at Goldman Sachs, an investment bank, says: “The future of the European Union now depends on the euro.”

Most European businessmen, as well as the financial markets, still believe that EMU will go ahead on time, though without Italy and, possibly, without Spain and Portugal. Any delay would prove expensive for banks and financial firms that have invested heavily to prepare for the euro. It would also be likely to drive up the D-mark to the detriment of German competitiveness. More seriously, many experts, including the IMF, believe that putting the euro on hold would create currency turmoil as markets started to make their own guesses.

Nor are the gains from delay all that obvious. It is conceivable that governments might use an extra year or two to deregulate, free up sclerotic labour markets and make their economies more competitive; but they are just as likely to seize the excuse to slow down politically painful measures. Meanwhile, interest-rate rises in Italy, Spain and probably France could make budget deficits worse and hit economic growth. In two years' time, the figures might turn out to be little better than now—and a second delay would surely kill the whole project stone dead.

Under the Maastricht treaty, the decisions on who, if anyone, qualifies for membership of the single currency should be taken next spring. Guided by recommendations from the commission, heads of government will vote on each country individually. Each applicant will need a qualified majority in favour to get in. There could be unattractive horse-trading of votes, including those of likely non-starters such as Britain and Greece.

Unattractive or not, it now seems more sensible, on balance, for the single currency to go ahead than to be delayed—if only for the negative reasons that delay could produce such devastating fall-out, and that cancellation might threaten the single market. But even if the euro is born on time, it will still give rise to arguments, not least because France still seems to have different views from Germany about the political governance of the new currency. Many French politicians have favoured it in the hope of wresting control over Europe's economies from the Bundesbank. Although the Maastricht treaty explicitly guarantees the European Central Bank's independence, a “stability council” of finance ministers will, the French hope, act as a political counterweight—even a precursor of an economic government for Europe.

This could prove thoroughly controversial. It could also further divide those who are in the euro from those who are not. In short, the EU could easily be dominated by the euro and the politics surrounding it not just up to 1999 but for some years afterwards. And that would continue to distract attention from other urgent EU business—most notably from preparations for enlargement.